Stochastic Dominance and Security Design
14 Pages Posted: 10 Jun 2011
Date Written: June 3, 2011
Familiar results from expected utility theory are reapplied in a risk neutral setting of security issuance under asymmetric information. The main result is that if 1) issuer qualities are ranked by first-order stochastic dominance and 2) securities and the implied residual claims are both nondecreasing, then the severity of adverse selection problems is increasing in the value of investment opportunities. With second-order stochastic dominance and concave claims (convex residuals) the opposite is true. Finally, the ordering of issuer entry/exit is precisely reversed in these two scenarios. The model is used to explain why certain mathematical assumptions are useful in the equity literature but not the debt literature, and vice versa.
Keywords: Security Issuance, Asymmetric Information
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